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Friday, September 26, 2008

The Financial Meltdown and the impact on CEP

Posted by Louis Lovas

Watching, waiting, wondering are the catch phrases of late. What will be the eventual conclusion of the meltdown and subsequent bailout of our financial system? Like many of you, I've been steadfast in my search for information, watching the news, reading blogs and op-ed's about how we got into this mess. I anxiously await our government's response. As a homeowner and family man with a retirement plan I am keen to understand this predicament. I also have a vested interest from a professional sense. The event processing technology in which we immerse ourselves is well entrenched in this same financial community.  Below I share a few thoughts and perspectives on our troubled financial times and how it might impact event processing technology.

Short Selling induced volatility

The idea behind short-sell trading is to sell an asset (i.e. shares of stock) that you the seller don't really own.  Then with luck the price drops, you buy the shares at the new lower price return the shares you borrowed and pocket the difference. Short selling strategies are common place in equities, currencies and futures markets and have been in use for a number of years. Which of course came to a complete halt when the FSA and the SEC banned short selling in an effort to stave off market instability. The FSA's clampdown gaged only a small number financial instruments, whereas the SEC's action was more punitive, setting restrictions on 800 companies. Once those regulatory bodies announced the crackdown the investment bank community, hedge funds and asset managers reluctantly scaled back their short selling strategies to comply. Short selling is a common use-case for CEP.  These recent restrictions are a clear indication of the need for algo strategies to be dynamically adaptable to market or regulatory conditions, whether in short selling or other types of strategies. It's imperative that the development tools provide the means to swiftly enable changes to strategies.

All told, the shorting restrictions were applied to those instruments that had massive impact on the market's stability. Just determining the market impact, the instability or general volatility was an investigative research project where CEP could have played a significant role. Volatility is a statistical measure of the scale of fluctuations in a price or index. By looking at historical norms, the FSA concluded 29 stocked exceeded those historical norms and the SEC determined it was 800. While I don't know if either regulatory body used a CEP product they clearly could have. Used in conjunction with a tick database for the historical market data, a CEP product like Apama provides the tool set and language to rapidly construct a market impact analysis solution with the ability to carry-out a multi-year analysis. 

Leveraged induced risk

Investment banks rely heavily on borrowed money, so much so the typical "leverage ratio" is 30 to 1. That means for every tangible dollar held, 30 are borrowed. While leverage can and does create the opportunity for huge windfall profits, it can also incur massive risk and huge losses. As long as markets are reasonably stable it allows for predictable behavior of investment strategies thus permitting banks to make money on borrowed money and continue to leverage.  However, as instability invades it erodes many aspects of investment strategies. Losses begin to mount -  on the investment itself, on the borrowed amount and the interest payment of the borrowed sum.

So how can CEP play a more active role in this highly leveraged world? With risk mitigation.  CEP is emerging as a key constituent in real-time risk management systems. One example is in deal-monitoring / position keeping systems. Auto-hedging is also a technique employed by risk systems to keep positions within the bounds of tolerable risk limits. One form of hedging is short-selling (see above). Risk management systems define allowable tolerances for trading, positions and P&L. With a 30 to 1 leverage ratio those tolerance limits seem terribly high. So when the market takes a turn for the worse, losses become astronomical. This is not the fault of the risk systems themselves but the allowable limits established by the bank's business then coded into the risk systems that permit highly leverage positions.   One can only image that investment banks will be adjusting the limits on their risk downward a few notches. It will also spark the opportunity for them to invest in newer more flexible real-time risk solutions. In volatile, ever changing market conditions risk systems need to be dynamically adaptable. CEP is an ideal technology to fill that need.

Reclassified Investment Banks

The last two major investment banks, Goldman Sachs and Morgan Stanley, have recently changed status from an investment bank to a commercial bank. In doing so they can now take deposits in the form of checking and savings accounts as a source of funds to shore up losses created by their highly leveraged positions. But commercial bank status means they face a litany of Federal regulation. For one, the 30 to 1 leverage ratio will be prohibited. The days of windfall profits in good times (and catastrophic losses in bad times) are over.  The Fed's also provide a safety net in the form of an emergency loan program for commercial banks. Goldman and Morgan now qualify to be protected by this net, thus preventing them from suffering the same fate as Lehman. I'm sure they had this in mind when they requested the change of status.  I wonder if Goldman and Morgan will be buying new name plates for the front entrances to signify their new commercial designation?

"In every crisis, opportunity" could be an appropriate catch phrase for the eternal optimist. While this meltdown certainly has the appearance of doom and gloom, in the end banks are in the business to make money and they will find a way. Event processing technology will be at the fore-front of that endeavor. Regulations will simply draw a box around which they operate. It will stir the creative spirit to achieve within these new boundaries. New forms of algo strategies, real-time risk monitoring and surveillance will be required as a result of the imposed bans and regulations. CEP technology - the Apama platform, will be at the forefront of this new (banking) world order.

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